Sublease space abounds

Life as a commercial real estate player in the City of Brotherly Love just isn't what it used to be. It seems like only yesterday that the 2000 Republican National Convention was in town, and the city was thrust into the national limelight.

Since then, tenants have dumped huge amounts of sublease space onto the market, and the nation's economic slowdown has hurt the city's retail and hotel markets.

However, Philadelphia is in the midst of a fierce debate about a project that could jump-start the city's center: the proposed $464 million expansion of the Pennsylvania Convention Center. This on-again, off-again project looks “off” once more, primarily due to labor issues. Supporters of the project predict a dramatic drop in the number of convention bookings if the proposal fails.

Still, Philadelphia has a lot to be thankful for, including the fact that it hasn't been as hard hit by the latest downturn as many other markets. The city boasts a diversified business base and is the sixth-largest tech sector in the United States, according to the University of Minnesota. Finally, there's a swanky $346 million ballpark under construction, which will be home to Major League Baseball's Philadelphia Phillies.

Subleases and freebies

Like a lot of U.S. office markets, Philadelphia has undergone changes recently. The city has felt the effects of mushrooming amounts of sublet space, a leveling off of rents and, in some submarkets, rent decreases and other concessions, said Gregory J. West, executive director of the Philadelphia office of New York-based Insignia/ESG.

From August 2000 through July 2001, Philadelphia's central business district (CBD), known as Center City, experienced a negative absorption of 269,023 sq. ft., according to Bethesda, Md.-based CoStar Group. The office vacancy rate in Center City rose from 9.4% in second-quarter 2000 to 10% in second-quarter 2001. Suburban vacancies increased from 11.7% to 13.8% in the same period.

“There are more large blocks of space than we've seen in years in both the CBD and Philadelphia suburbs,” said William G. Luff Jr., senior vice president and director of brokerage in the Philadelphia office of Dallas-based Trammell Crow Co. “This is primarily a direct result from new construction and rehab deliveries. The good news is that market economics remain relatively stable. Tenant decisions are based on the overall criteria, not just the bottom fishing for economic opportunities.”

Despite the bad news, there is new construction. Among the largest office projects downtown is Malvern, Pa.-based Liberty Property Trust's plan for a $390 million, two-tower office complex at 17th Street and JFK Boulevard. The 50-story first tower is expected to contain 1.4 million sq. ft., and the 16-story second tower will feature 285,000 sq. ft. Liberty plans to break ground on the first tower in May 2002, said Willard Rouse, Liberty's chairman. He termed the Center City market “ripe for new building.”

Another sign of life is the investment market. In August, Philadelphia-based Susquehanna International Group acquired 401 City Ave. downtown for about $100 million, making it the largest transaction in the city this year. Susquehanna plans to use the building as its headquarters.

Denver-based Amstar Group Ltd. also purchased the 577,400 sq. ft., 20-story office tower at Three Benjamin Franklin Parkway downtown from Reliance Insurance Co. for an undisclosed price. Meanwhile, the 1.2 million sq. ft. Two Liberty Place, one of Philadelphia's most prominent office towers, was recently put up for sale. The building was placed on the market about a year after the $215 million sale of the adjacent One Liberty Place, which fetched $180 per sq. ft. Most local brokers expect Two Liberty Place to pull in between $120 per sq. ft. and $175 per sq. ft.

Despite all the recent activity, the leasing environment has tenants taking a look-and-see approach. “Clients are generally taking a much longer time from inspection to execution,” said H. Hetherington Smith, senior vice president and branch manager in the Philadelphia office of New York-based Julien J. Studley. “Rates that were escalating rapidly are showing signs of leveling off. Overall, the Philadelphia market has performed very well, despite some slowdown in leasing that is reflective of the general economic downturn.”

Philadelphia is not alone in feeling the technology crunch that has gripped much of the nation. Several major telecom developments have been halted, while others look for new tenants after the market for telecom tenants dried up overnight.

“Telecom/technology buildings are in trouble in this market,” said West. “There is more sublet space and less confidence. It's really back to basics.”

Luff agrees, noting that the tech downturn has resulted in a significant amount of sublet space in the suburbs, which has left the market with some discounted rate opportunities. “The CBD was not significantly affected by the tech sector,” he added.

Smith said the tech wreck hasn't had a huge impact overall, mainly because the local technology companies are relatively small in size and widely distributed throughout the region. But, he added, “There are a couple of large telecom carrier hotels in the North Broad Street area with about 1.5 million sq. ft. of space that are still looking for tenants.”

How long the tech fallout will last remains anybody's guess at this point. “Rents are falling and concessions, such as increased tenant improvements, free rent and rent reductions, are becoming more prevalent,” said Matthew Feeney, principal in the Philadelphia office of CRESA Partners. “We anticipate that this trend will continue as a result of pressure from the sliding economy.”

Philadelphia's core tenant base is in the healthcare, bio-tech, pharmaceuticals and legal industries. But these sectors are staples of the suburbs these days, where there are better tax incentives and skilled labor, according to Philadelphia real estate players. And while there is a lot of action in the CBD, most observers admit the suburbs are crucial to Philadelphia's future growth.

West of Insignia/ESG is big on the Route 422 and 202 corridors, as well as the Lehigh Valley area due to its proximity to northern New Jersey and New York City. Feeney holds the King of Prussia market in high regard, especially as the Route 202 expansion/construction project nears completion. “The increased access is expected to attract tenants and rejuvenate the area,” he said.

Luff also is a fan of the King of Prussia submarket, particularly since Trammell Crow has a new development in the area: Atwater Office Park, a 2.6 million sq. ft. project located in Malvern with easy access to U.S. Route 202, U.S. Route 30, Schuylkill Expressway (I-76) and the Pennsylvania Turnpike (I-476). He also is big on the Conshohocken submarket, where five different projects totaling 860,000 sq. ft. will be delivered in 2002.

Smith signals one note of caution, pointing to the possible inward migration from the suburbs. “Sublease space continues to be a factor, and could start to have an impact on the far western suburban market,” he said. “The space coming available allows tenants that usually occupy this submarket to move to higher-quality buildings closer to Philadelphia. We're also seeing some nearer suburban markets — King of Prussia, for example — experiencing an increase in lease concessions and more liberal expansion rights.”

Retail trends: Economic realities

Philadelphia has long been known for its department stores. It seems there are dozens of them everywhere you look, starting with the John Wannamker store at 13th and Market streets downtown.

But today, Philadelphia's retail market is much more inclusive. It has expanded in depth and breadth, and now the market is home to the 2.9 million sq. ft. King of Prussia Mall.

Two new large entertainment-oriented ventures have been proposed for downtown, one at Penn's Landing and the other at 8th and Market streets. The Penn's Landing development is at the epicenter of a revival along the Delaware River, an area long neglected. A new Hyatt Regency Hotel has opened in the same area, and Indianapolis-based Simon Property Group's Family Entertainment Center is on schedule for completion in late 2002. The center will feature approximately 550,000 sq. ft. of rentable space for entertainment-oriented tenants.

But without a doubt, economic realities have hit the local retail market. “Consumer sales are stable at best. Generally, profits are flat or trending down, creating a gap between seller and buyer price expectations that is holding back sales velocity,” said Jeff Algatt, regional manager of the Philadelphia office of Encino, Calif.-based Marcus & Millichap. “Sellers still are reluctant to sell into this weakening market, while buyers are waiting for the bottom.”

As in the rest of the nation, labor availability has become a significant issue for retailers in Philadelphia. According to George Gati, a leasing agent with Marcus & Millichap, qualified labor is hard to attract and retain, which depresses sales, raises costs and makes the decision-making process on new store openings more difficult, except in the best markets where retailers will bear almost any cost to be represented.

“Operators are paying more attention to careful placement of new stores relative to their competition, as opposed to ‘the more, the merrier’ attitudes of recent years,” said Margay Grose, a senior associate with Marcus & Millichap. “Going head-to-head is not as casual a decision anymore.”

However, the economic slowdown may not affect the Philadelphia retail market as much as other parts of the country. “The Philadelphia metropolitan statistical area (MSA) is not as volatile a retail market as many other MSAs and has not experienced material overbuilding and valuation spikes,” said Susi O'Meara, research manager with Marcus & Millichap.

The investment vehicle of choice remains grocery-anchored centers, new malls in suburban growth areas and free-standing retail at the best intersections.

The worst retail performers are stores and centers in secondary markets, older centers — especially where anchors and big boxes have gone dark — and outlet centers, said J.D. Siemsen, an agent with Marcus & Millichap. Of note is the expansion of upscale grocer Genuardi's, based in Norristown, Pa., which was purchased by Pleasanton, Calif.-based Safeway earlier this year. The company has completed or started construction on four new stores throughout the Philadelphia area and will add nearly 180,000 sq. ft. to the market. Albertson's also is active with some 175,000 sq. ft. in the works for the region.

Hotels: The good, the bad and the ugly

Listen to local hotel expert Peter R. Tyson, director of Horwath Horizon Hospitality Advisors, and you immediately understand where the Philadelphia hotel market stands these days. “The lodging market in Center City Philadelphia can be summed up using the old cliché: ‘I've got some good news, and I've got some bad news,’” Tyson said.

The good news is that since mid-1998, 12 new hotels have opened in downtown Philadelphia and two others have expanded, enabling Philly to boast an array of quality hotels the city has not seen since World War II. The bad news is that demand has not been able to keep pace with supply.

According to Tyson, Center City now offers some 11,400 rooms per day vs. some 6,600 in early 1998 — a dramatic increase of nearly 73%. Annual increases in supply were 17% in 1999 and 25.3% in 2000, plus another 14.5% in the first six months of this year.

New entrants to the market include Loews, Hyatt, Hawthorn Suites, Courtyard by Marriott, Sofitel, Hilton Garden Inn, Radisson and Hampton Inn. The Ritz-Carlton brand recently switched to a new facility.

Unfortunately, demand hasn't kept pace with the new supply. Center City occupancy rates have continued to drop, from 73.4% in 1997 to 63.4% in 2000. Tyson estimates that occupancy will be even lower this year, around 59%.

In 1998, 1999 and 2000, Center City's average daily room rates (ADRs) held their own, with increases — 8.8%, 1.3% and 3.3%, respectively — that were at or above inflationary levels in those years. So far this year, however, ADRs are down 4.2%, a good indication of a competitive rate environment.

New construction is always the wild card, but in this case the news is good, as not many hotel projects are under construction. Tyson points to the much-publicized case of actor Will Smith and his brother, who had cleared a site for a W Hotel in the New Market section of Center City but recently announced an indefinite postponement.

Given the slowdown in new construction, Philadelphia real estate players are hoping that demand will get a chance to catch up to supply, particularly since 2002 looks to be a banner year for bookings of city-wide conventions. Occupancies are expected to range from 65% to 69% in three to four years, according to local market observers.

Ironically, the current hotel woes might stimulate support for an expansion of the Pennsylvania Convention Center to help fill the new beds. So far, though, the city's hotel leaders have been reluctant to support a hotel tax increase to help fund the project.

Apartments: Sittin' pretty

The apartment market is one of Philadelphia's hottest property sectors, and both downtown and suburban locations are in the mix.

“Empty-nesters and young, two-income couples can't get enough of the luxury Center City renovations coming on line,” said Linwood Thompson, national director of Marcus & Millichap's National Multi Housing Group in Dallas. “These units are leasing as quickly as they can be delivered.”

In such a hot market, are investors flocking to the local scene? Not yet, Thompson said. “Sales velocity is slowing, mainly as a result of limited product available for potential investors,” he explained. But, the good news is that money is still plentiful due to uncertainty in the local office and retail sectors, and the stock market volatility.

While many other markets have been struck down by the technology downturn, Philadelphia's apartment market seems to be shaking off any ill effects. “The national technology crunch has had minimal effect on the Philadelphia MSA,” Thompson said.

“The fallout that has occurred has been primarily in Center City where the bulk of the ‘dot-comers’ leased apartments,” said Thompson. “However, the overall resurgence in Center City apartment leasing has counterbalanced any dot-com retrenchment.”

He points to the area's diversity of businesses and its long history of never becoming overly dependent on any one business sector, including the tech sector. A key barometer of any healthy real estate market is the ratio of supply to demand. In Philadelphia's case, demand for apartments is greater than supply, and local municipalities have made it difficult for new development, particularly in the suburbs.

“Many Class-A and B properties throughout the MSA find themselves with waiting lists, and only have vacancies while an apartment is being renovated for a new tenant,” said Marcus & Millichap's Algatt. Continued suburban population growth in Bucks and Chester counties in Pennsylvania and Burlington, Camden and Gloucester counties in New Jersey should fuel the pattern of tighter market conditions and increasing rents, he added.

Meanwhile, redevelopment is the name of the game in and around Center City as developers look for their next conversion opportunity to capitalize on strong demand, limited supply and generous city incentives.

Another health barometer — apartment rents — are holding up their end of the bargain, particularly on the Class-A end of the spectrum. Not unexpectedly, Center City commands the highest average rent for Class-A properties, approaching $1,600 per month, with rents as high as $3,000 per month for three-bedroom units.

According to Marcus & Millichap's latest quarterly rental surveys, rents in many Philadelphia markets increased between 2% and 5% from July 2000 through June 2001.

Continued development of new luxury units, and redevelopment of old industrial and office properties, will add more high-priced stock to the area, and should keep rent and value on parallel growth paths.